By Notable Calls: Monday February 1, 2010
Citigroup is out downgrading Lubrizol to Sell from
Hold whole lowering their target to $67 (prev. $78).
Citi notes there was a new data point in lubricants
that came out on Friday from NewMarket, one of
Lubrizol's main competitors. NewMarket's lubricant
additives margins dropped sequentially from 23.3% in
3Q'09 to 16.4% in 4Q'09 as raw material base oil
prices went up faster than lubricant additive
prices. They think this is the first crack in the
lubricant industry. Lubrizol's Lube Additive margins
had skyrocketed from a historical average of ~12% to
~28% in both 2Q and 3Q 2009. They are downgrading LZ
despite the 7% drop in the stock on Friday for three
key reasons:
- Firm notes they have seen similar examples of
margin erosion in other chemical products such as
Monsanto's Roundup and the fertilizer potash. In
both these products, margins skyrocketed after
having been stable for several years. In the case of
Roundup, the Chinese entered the market and crushed
margins in 2009. Recently in potash, the oligopoly
structure did not hold up well, dragging down
profitability. The reasons may be different in each
case, but the outcome was the same.
Lubrizol's lubricant margins hovered between 11%-13%
for most of the decade before moving higher in 2009.
The reason for the margin expansion was that raw
material base oil prices collapsed in 2009, while
final lubricant prices did not fall as much. As a
result, there was an unprecedented margin expansion,
when margins reached 28% in 2Q'09 and 3Q'09.
Lubrizol may post good results in 4Q'09 when it
reports on Thursday (2/4), but NewMarket's results
have shown the vulnerability of these margins to
higher raw material costs. Can lubricant prices go
up from here even if they did not go down in the
recession? Citi thinks there could be pushback from
customers such as engine oil and other lubricant
manufacturers, quick lube chains, retailers such as
AutoZone and Wal-Mart, or OEM players in the
automotive and construction industry.
Given that Valvoline is one step downstream from
Lubrizol, the firm expect its margins to be a
leading indicator for LZ. Valvoline's margins peaked
in 2Q'09 and have declined for the last two
quarters. NewMarket's margins peaked in 3Q'09 and
declined from there, roughly one quarter behind
Valvoline. Firm expects Lubrizol to broadly follow
the same pattern in the long run. LZ may post a good
4Q due to its cost cutting initiatives, but Citi's
call today is not about the fourth quarter; it is
more about the next 12-24 months.
- Citi thinks high operating margins of 28% could
attract new investments by existing producers or new
players to the industry. Lubrizol has already
announced a new $1B capital program over the next 10
years to upgrade existing operations and to build
capacity in additives. The centerpiece of the
initiative is a greenfield expansion which involves
an investment of over $200 mm over the next three
years in building a new plant in Southern China.
Lubrizol plans to break ground in late 2010 and
would likely export products throughout Asia. Citi
notes they wouldn't be surprised if Chinese oil
companies or others enter this business given
attractive margins and China's growing passenger car
market and industrial lubricant needs.
- Citi is lowering their Lube Additives margin
assumption from 23.5% in 2009 to 18.5% in 2010 and
16% in 2011. Our long-term margin assumption of 16%
is higher than Lubrizol's historical margin range of
11%-13%. A 1% change in Lube Additives margin
impacts EPS by roughly 40¢/share, so there is
significant sensitivity to Lube Additives
profitability. Firm estimates that the Lubricant
Additives segment accounted for ~85% of total
company profit in 2009, while historically the
segment was 60%-70% of total profit.
Firm is lowering their earnings estimates for 2010
(by $0.23 to $6.74) and 2011 (by $1.27 to $6.07) to
account for lower operating margins in the Lubricant
Additives business.
